Market volatility, budget deficits pose test for Fed's Powell

DAYTON, Ohio (Reuters) - When the Federal Reserve's policy meeting ended last month, U.S. stock indexes were near record highs, market volatility was almost non-existent and policymakers chatted about the calm waters welcoming incoming central bank chief Jerome Powell.

Now, Janet Yellen's successor may instead be facing an early test of his leadership as the Fed weighs the significance of a recent market downturn and jump in long-term bond yields as well as the risk the Trump administration's tax and spending policies may light the fuse of unexpectedly fast inflation.

Powell's views will become clearer when he testifies separately before lawmakers in the U.S. House of Representatives and Senate during the week of Feb. 28, and holds his first press conference as Fed chief after the March 20-21 policy meeting.

Investors widely expect the central bank to raise interest rates at its March meeting.

New U.S. inflation data on Wednesday may also indicate whether the pace of price increases is accelerating, which will be good news for a central bank that has struggled to hit its 2 percent annual inflation target - unless it comes too fast.

Meanwhile, the market turbulence this month "will worry them and induce considerable hand-wringing," UBS economist Seth Carpenter said in an essay that asked whether Powell would delay a March rate hike to steady financial markets.

Not likely, said Carpenter, but he added that the selloff put the Fed in the quandary of determining whether the sudden market wobbliness is more important to policy than the recently passed tax cuts or an expected rise in U.S. government deficits.

Last week, the U.S. Congress passed and President Donald Trump signed into law a temporary spending deal expected to push budget deficits past $1 trillion annually with new military and domestic outlays.

On Monday, Trump proposed a budget that called for spending $57 billion less in fiscal year 2019 than mandated in last week's deal.

'UPSIDE RISKS'

Powell's colleagues at the Fed so far have said the central bank should stay the course, gradually raising rates along the path Yellen set and neither reacting to the recent market turbulence or jumping to conclusions about the impact the tax cuts and higher deficits could have on inflation.

But they've also made clear they are looking closely at all of the above, which will make Powell's first months as Fed chief more complex than they seemed a couple of weeks ago.

"There are more salient upside risks to the forecast than we have seen in quite a while," Cleveland Fed President Loretta Mester told reporters on Tuesday after a speech in Dayton, Ohio, flagging the possibility the extra spending generated by tax cuts and a rise in budget deficits could throw off the Fed's outlook for growth, inflation and other aspects of the economy.

"It is going to be important to evaluate how firms and households are responding."

"Who knows?" Mester said. "The financial markets may be a risk on the downside if we do see a pullback in confidence. We have not seen it so far. I am not anticipating it."

As stock markets were plummeting last week, San Francisco Fed President John Williams said he felt investors in a sense were playing catch-up - finally accepting the fact that central banks would continue raising rates, and repricing stock and bond investments accordingly.

"I think some of the market reaction is the fact that the economy is doing well," Williams said, calling the rise in long-term bond yields "maybe delayed recognition" that global economic growth will continue and central banks will raise rates as a result.

(Reporting by Howard Schneider; Additional reporting by Ann Saphir in San Francisco; Editing by Paul Simao)